"The price of borrowing money is interest—and worry. Keep all borrowing below the worry point and don’t borrow to buy things that depreciate; you will lose on both ends." - Ron Muhlenkamp from his Basic Maxims I Want My Kids to Know.
Cars, vacations, iphones, new bicycles, dinners out at restaurants etc... all lose their intrinsic value the second they are purchased. Yet people put them on credit cards or take out loans to buy them and carry the balance for months or even years. So not only is that meal you spent $100 on long gone, but you are now going to pay an additional 10-20% (or possibly more) because you didnt pay it off right away. Bad idea, Genius. One of our rules is that we don't buy anything on credit or loan if it depreciates over time. We view paying more to buy something by spreading the payments over time for something that goes down in value as a silly thing to do. I know people who buy stuff on credit cards because an item is on sale and then don't pay it off for up to a year or more, essentially negating the sale price.
But the biggest sting is on big ticket items... so let's look at a big ticket example. Onethat most people can relate to would be a car purchase. Suppose you bought a car for $25000 and you financed 100% of it for 5 years at an interest rate of 5%. You'd pay about $471 a month in payments. The car will depreciate 10-15% per year depending on make and model. For this example, lets assume 15% depreciation. After 5 years you are still paying the $471 per month, but your car is now only worth a little over $11000. When you finish paying for it, you will have paid about $28306 once you add in all the interest. By paying for the car in full at least you would avoid paying the extra $3306 in interest. A big part of my apprehension is psychological. I recognise this, but I still think its worth thinking about, You will pay $5600 in the final year in monthly payments, and your car will only be worth the equivalent of 2 years worth of payments... yeah, that stings.
What if you did without a car for a few years and saved $471 up front each month, how long would it take to save up the 25000 in cash? Lets also assume you can get a 5% return on your savings. According to this handy online calculator, it would take 48 months to save up 25000 to pay for the car in cash. You would actually only have to put up $22600 of you own money, and the compounding at 5% per year would do the rest. You've saved yourself $5700 dollars and you own the car outright. You can keep saving $471 in your account for your next car that you will pay for in cash. Since we know you can probably replace your current car for $25000, you will be able to save up the money for your next car in 4 years! This is generally how we operate. Save and then buy. Not borrow, buy and then pay down.
But I'm not against borrowing.... I just dont like to borrow on things that depreciate. I do however like to borrow moneyfor safer investments or assets that provide some cashflow.
Lets look at borrowing to invest in something that appreciates in value, rather than depreciates. (NOTE: you should know by now that I don't usually fuss too much over capital appreciation in the short term, but for this example lets assume that capital appreciation is the goal. We will also not consider taxes for this example even though I know taxes will take some in the end if you sell the investment) We will borrow at 5% and buy a $25000 investment that appreciates (and therefore compounds) at 5% a year instead of depreciating like the car. After 5 years, you will have paid the same as the car, $28306, but now the investment is worth $31,907. So in the case of borrowing to buy a car vs investing, I could borrow to buy a car that will cost me 28k over 5 years and then its only worth about 11k when I pay it off, OR I can borrow and pay the same amount over those 5 years on something that appreciates over time and it would be worth about $3600 more than what I paid for. So to compare both scenarios with their bottom lines, the depreciating car has lost about $17300 of what you've put into it, and the investment is up $3600. That's a difference of nearly $21000. Well, when you put it that way Ryan, that IS a huge difference.
This is the way we've set up a portion of our finances. We only borrow for things that increase in value such as investments, and we save up to buy all things that depreciate.
